Turbulence likely for markets at fever pitch

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As 2005 drew to a close, the headlines were grabbed by Hong Kong as a result of its belated entry into the Asian REITs market. The Link REIT issue was greeted with a feeding frenzy, hitting a price 45% up on the opening level, with the yield having come down below 4%. And the massive over-subscription of the Prosperity and GZI China REIT suggests it will take a few more issues to satisfy demand – and there are at least six new issues ready to be brought to market. The huge capital growth of REIT issues at various times - in Japan, in Singapore and now in Hong Kong - obscures what is supposed to be the main reason for their popularity : a demand for income-generating investments. As Michael Smith, Asia head of real estate at UBS, says: “You have the Link REIT yielding less than Hong Kong’s 10-year sovereign debt.” Investor demand for REITs will remain strong as long as dividend yields continue to offer an attractive spread over fixed income alternatives. The chart shows the typical spread between gross property yields and government bonds in the major REIT markets. The premium being asked for some of the new issues is creating an unsustainable situation. The fevered environment encourages hedge fund activity but certainly not investment by pension funds. Commenting on the tendency for REIT share prices to display different characteristics over a longer period, CB Richard Ellis suggests that investors “should be prepared to take a longer-term view and put REITs in their proper perspective as a vehicle providing stable income rather than growth”.Japan exemplifies the growth of Asian REITs, with 26 having been listed, 11 in 2005 alone. The combined market capitalisation of these issues was ¥2.6trn by October 2005. And despite a healthy rise in unit prices, J-REITs still offer a good yield spread over government bonds. A slowdown in REIT capital returns is expected in 2006, with suggestions that the underlying markets might be overheated and with the risk of interest rate rises remaining high. Institutions have been less inclined to back the REIT issues in Japan of late, because of rising prices and lower returns, according to a survey released by the Association for Real Estate Securitisation. Mr Smith observes that: “Investors are becoming more discerning when it comes to the quality of sponsor and the investment story.”In contrast with the US REIT market, which outperformed the broader equity market during 2005, Asia Pacific’s two main listed property sectors significantly underperformed their local market indices. For the 12 months to the end of October, the J-REIT market was up only 7.2% compared with almost 35% for Japanese stocks overall. In Australia, where the listed property trusts sector went through a painful downturn in the first part of 2005, LPTs returned 12.3% for the 12 months to end October, compared with 23.2% for the ASX overall. The long-term picture is quite the opposite, though, with REITs coming out on top over five years across all three major world markets. Annualised returns over five years to the end of October were 16% for J-REITs and 9% for the Topix equity index, 19.4% for US-REITs compared with 4.2% for the S&P 500 and 15.5% for LPTs compared with 12.5% for the ASX 200. Individual market differences are worth noting. The US is a much deeper market and demonstrates significantly greater volatility than the other two. Hong Kong investors have snapped up the first wave of REIT offerings and moving into the 2006 listing schedule there are at least five more in the pipeline. There is also the opportunity for REITs listed elsewhere, in Singapore for example, to apply for a secondary listing in Hong Kong. Justin Chiu, chief executive of ARA, the manager of the Prosperity REIT and also the Fortune REIT listed in Singapore, would like to see the Fortune REIT gain a listing in Hong Kong. Both these REITs contain assets of Asian property giant Cheung Kong. There has been little or no talk of Hong Kong REITs seeking to undertake a secondary listing in Singapore and this will be a testing issue for Singapore’s attractiveness as an Asian REIT market. Mr Smith asked: “Will the Fortune REIT go back to Hong Kong? Pricing is the key. If one or other centre can come up with a compelling case, that will swing it.”With six REITs and a market capitalisation of $8.7bn, Singapore is still Asia’s second-largest market. The Singapore government has made great efforts to give its market the edge in terms of tax exemption and the waiver of stamp duty in transferring assets to a REIT and the reduction of withholding taxes for foreign institutional investors. In spite of its attractions at a cost level, Singapore suffered a setback in December when Macquarie Real Estate postponed the Singapore listing of its International Real Estate Fund because of poor demand from institutional investors. Macquarie blamed the delay on a softening of Singapore’s property fund market and competition from other capital raisings. Local analysts do not believe this will adversely affect Singapore’s status as a REITs listing centre, suggesting instead that Macquarie’s offering simply didn’t hit the mark with investors. Some suggested the issue was actually “too sophisticated” for the market at this time. Clearly not all REIT issues are guaranteed to succeed.Much has been made of the decision by the UK’s TCI Fund to buy an 18% stake in the Link REIT. It has been suggested that such activity will lead to greater volatility in REIT share prices and that hedge fund pressure for higher returns will drive up rents. But as Mr Chiu points out, it is a common occurrence in other markets, including Singapore, Japan and Australia, so the TCI stake is not necessarily a bad omen.

Looking at wider market trends, cross-border REITs are likely to be the big story in 2006. The high population countries such as China, India and Indonesia have no real prospect of putting their own REIT markets in place in the foreseeable future, which presents a great opportunity for such centres as Hong Kong and Singapore. Hong Kong has a natural advantage as a listing base for China. Singapore is well placed for India, the Philippines and Indonesia. Mr Smith says: “There’s already a huge amount of cross-border activity. By the end of the decade, Asia will have a much bigger REIT market than Australia.”Investors tempted to venture outside the big-four markets of Japan, Singapore, Australia and Hong Kong will probably look at Taiwan, Korea, Malaysia and Thailand. Yields on Korean REITs are currently in the range of 6-7%. South Korea is extending tax incentives to externally-managed REITs and easing the borrowing and initial capitalisation requirements. Two new REITs came to the market in 2005, including the first general K-REIT that can enjoy tax exemptions without having to participate in corporate restructuring.Malaysia’s government has taken a pragmatic approach to its often complex regulations and the local REIT market has received a boost from the easing of ownership regulations and the introduction of tax transparency. Malaysia’s first REIT, the Axis, was launched in August 2005 with an indicative yield in the 7-8% range. This has since come down to around 5% because of price appreciation. Taiwan’s first two REIT flotations occurred in 2005 – the Fubon and the Cathay No 1. The unit prices of both have remained stable since launch in spite of substantial volatility on the local bourse. Thailand’s public property funds market is also booming, with the listing of six property funds in the year to October 2005, carrying yields in the 6-8% range. The problem with these markets is that they don’t make it easy for foreign investors. Mr Smith says: “You have the main markets such as Hong Kong and Singapore. Then you have the local markets such as Malaysia, Taiwan, and Thailand where most of the activity will involve domestic product and domestic investment. Thailand doesn’t encourage foreign ownership. In Taiwan there are foreign ownership restrictions and the regulatory framework is pretty poor.”So, to conclude, in 2006, we can expect a lot more excitement from the Asian markets. But as one commentator observed: “There’ll be pain alongside the joy.”